I used a variety of metrics to crunch numbers and evaluate what I believe is to be the fair or intrinsic value. This is the most important site that investors need to watch for as it will assess all valuations from ratios that analyze debt, liabilities, equity, growth, performance, and market health. Though this only comes in six valuations, all six play an integral component in analyzing the fair value of the stock.
Benjamin Graham was a professor at Columbia University and was often referred to as the father of investing. In the 1960s, Warren Buffet claimed that he learned a lot from Graham in terms of the principles of value investing. The most important lesson Buffet learned was to buy the stock at a margin of safety. Typically, this is between 15-20% to ensure that expected returns or yields are met within the given time frame. In this way, Warren Buffet made 30%+ per year in rate of returns and he was able to do so as he knew the significance of value investing and not approaching things just because the numbers look good. In this perspective, I took up a project to find such a value and also find the margin of safety which can be seen at the bottom of any stock page.
There are a dozen variations of the Graham formula and this was a problem so I want to make it perfectly clear. The Graham formula is EPS * (8.5 + 2 * (Stock Growth Rate)) * 4.4/yield. The common misconception is that people use this formula to apply to today’s value, when this formula really applies to what the price should be in 7-10 years. Then to work backwards, simply find a terminal value to account for what the graham value should be today.
Notice, Graham used 4.4 and yield to compensate for the economic climate. The yield stands for the AAA corporate bond yield and brings in the picture of interest rates and inflation. The lower the corporate bond yield, the lower the interest rates, the higher the inflation, indicating a higher stock price. This correlation is important to keep track of especially in the valuation of stocks!
All Ben Graham values looked pretty high and it carried the overall fair value to a higher price than today, surprisingly. I don’t think however that the equation needs to change. It is good, but one must factor many things in today’s economic climate. Does this mean that the metric 4.4, 2, or 8.5 change? I will continue my research here, but for now let’s stick to the original.
One of the most important metrics used in my calculations was the sales valuation. This holds 40% of weightage and contributes the most along with earnings. It is mainly used for companies in resilient situations and due to the crisis we are in, I emphasized such a valuation. The lower this P/S ratio is, the more sales the company is generating and in comparison to earnings it matters more because growth in revenues is what makes companies grow, not profits. Profits may be increased due to layoffs or cuts in expenses that are not necessarily beneficial, but steady growth in revenues or sales is the backbone behind the true growth of the company. Amazon, for example, in its very early stages reported negative earnings which would not attract investors as it was not turning a profit. But if you looked closely, you would see growth in sales and this growth is what led Amazon to be the biggest company in the world. I calculated sales through revenue and price to sales ratio. The final formula was Revenue * P/S Industry.
Earnings is the second most important valuation that accounts for my fair value. It represents profitability. This also is the most integral component within a company’s financial statements. This directly correlates to the performance of the company and the future growth prospects. There are also earnings estimates that are reported and if this target is met, investors primarily focus on such businesses and assess other factors to maybe make an investment. Many companies actually failed in meeting earnings which is another way of saying net income after taxes, so net net income. Amazon was one of these companies when it was born. It was a loss making company and though revenue consistently grew, it would never reach the level of operating expenses. Investors would easily ignore such a stock due to its earnings alone, but if they payed attention to sales, they would think otherwise. Earnings is an amazing way to value a stock as it is on the basis of profit, however, there are other metrics that one must consider. Never, just go off of one metric. I have selected 5 others that are also very important to look at.
To calculate earnings, I used a combination of P/E and EPS ratios. These are both powerful tools to determine whether a stock is undervalued or overvalued. The higher the P/E, the more overvalued the stock is. 10 used to be a good P/E ratio, but the current norm is now between 20-40. Amazon is near 100. Remember, P/E * EPS is stock price. I tweaked this to give a more appropriate valuation. My final equation was EPS * P/E Industry.
Enterprise Value is probably one of the most significant valuations as it has to do with company acquisitions. If the company had to be acquired, the estimate would be the enterprise value. This gives an accurate representation of the company’s value as it includes debt. This is similar to the Book Value representation as the liabilities of a company is mainly its debt.
It also includes EBITDA which is earnings before taxes, earnings, depreciation, and interest. This is probably most important to compare companies within the same industry. My calculation was hence, EBITDA company * EV/EBITDA industry average. The EV/EBITDA multiple is used to determine the valuation of a company. 7.5 is the quintessential multiple for a good valuation.
Free Cash Flow
Free Cash Flow represents cash flow within a company and usually the growth of this should be consistent with the stock price. This ratio should hence remain stable and overall FCF only accounts for cash in the financial statement. This is very important in terms of reinvestment in company growth or extending the customer satisfaction with dividends. Though Apple’s dividend is 1%, this is a huge amount and accounts for 27% of FCF. Dividend growth is one way of valuing companies and is also represented in the Gordon Growth Model as well as the Discount Cash Flow Model, used to find the intrinsic value in companies.
The formula I made for this valuation was (Price/Cash Flow Industry) * (Stock Price) / (Price/Cash Flow company). It basically takes a ratio of Price/Cash Flow between company and industry. That ratio multiplied by the stock price would finally be my final valuation.
Finally, book value is a perfect metric to measure as a valuation. It encompasses the equity of the community, which accounts for the company’s assets subtracted by its liabilities. Yup, I took a course on accounting!
The book value is especially important to investors as this value captures a lot from a financial statement. Even better, it can be narrowed down to a simple ratio: BVPS which stands for Book Value per Share. Book Value represents what the market capitalization of a company should be near, but BVPS narrows it down to the stock price and can also be represented as a ratio: Price to Book (Stock Price / BVPS). Typically, bigger companies have a very high Price to Book values as their stock price is not representative of their actual equity. Stock prices are usually inflated numbers and so a typical Price to Book is around 20 saying that the stock price hype is twenty times the amount concluded by the company’s actual financial reports. It might sound absurd, but that is the stock market we live in today.
On with the calculations. To figure out my valuations I used industry standards and compared it to company financials to get a more solidified valuation. My book value is calculated with the formula: BVPS Company * P/B Industry. This simple calculation actually provides a realistic value of what the company should be worth and has been pretty accurate in comparison to my final fair value.
When appraising a house value, one must assess the location in regards to nearby hospitals, schools, gyms, shopping centers, etc. They must look at how the house can appreciate in value and depreciate in value. If potential tenants were to reside in the property, it is important to calculate estimated revenue from tenants and the expense that goes in managing a property. Appraising a stock has similar facets and in order to truly determine the value, the 6 valuations I chose are perfect for investing and getting a better edge on the stock market. Happy investing and best of luck to you all!